Economist, Telegraph Columnist, Broadcaster

Gilts Market Jitters That Could Threaten Global Recovery

George Osborne is right. News that the main measure of UK inflation turned negative for the first time since 1960 isn’t a cause for concern. Yes, prices in April fell, which means deflation is official – and that hasn’t happened for over half a century. As the Chancellor says, though, UK deflation is far from entrenched and will rapidly reverse.

I’m more worried about early but significant signs of distress on Western sovereign bond markets. Our newly elected Government should be worried too. The British state is still borrowing very heavily, servicing an ever-growing debt pile. And if the UK gilts market goes haywire, with yields rising as investors demand higher returns, that would upend the economic recovery and put a somewhat different gloss on the Tories’ second term.

This isn’t, as Osborne put it, “damaging deflation”. That’s when prices stay negative for months or even years – as in Japan at various times over recent decades. Consumers then delay purchases, business revenues dwindle and investment stalls – as debt burdens, in real terms, get heavier.

When such deflation really takes hold, economic incentives become warped, with falling prices reinforcing each other and creating a disastrous downward spiral. The UK isn’t remotely in that position. The consumer price index was 0.1pc lower in April than the same month last year, having been flat in both February and March. The negative April number was partly due to supermarket price wars driving a 3pc drop in household food costs.

It was mainly, though, because oil averaged just $60 a barrel last month, compared to $108 in April 2014 – resulting in much lower petrol prices and energy costs across the board. The broader retail price index registered 0.9pc inflation last month. Prices across the service sector, more than three quarters of the UK economy, were a full 2pc up.

But far lower fuel and transport costs were still enough to turn the overall CPI figure very slightly negative. And that only happened because of a quirk of the moon. In 2014, Easter fell in the middle of the month, during the few days when the data used to calculate CPI are always collected.

As such, the prices of air and ferry tickets used in last year’s index reflected higher Easter holiday rates. This year, with Easter in early April, such prices were at normal levels during the mid-month collection period – which, combined with the cheaper fuel effect, meant they were far lower year-on-year.

Were it not for that wrinkle in the lunar calendar, the latest CPI inflation number would have stayed positive. And with lower energy and transport costs set to soon start falling out of the figures – given that oil began its sharp drop last summer – this tiny UK deflation will soon be viewed as a statistical blip.

Most analysts judge that none of this affects the timing of the Bank of England’s first interest rate rise since mid-2007. The minutes of the Monetary Policy Committee’s May meeting show a unanimous vote to hold rates at 0.5pc, while still pointing to late spring 2016 as the most likely time for an increase, with inflation by then gently rising towards the 2pc target.

It strikes me, though, that inflation could come back more fiercely. With oil prices some 40pc above their $48 low in January, fuel and energy inflation could spike this autumn. Crude is already dearer than in November last year. Consider also, that ministers from leading Opec members are now pointing to rising prices, with both Kuwait and Iran uttering last week. Having kept oil down for a while – knocking out a raft of high-cost, heavily indebted US shale producers – the Saudi-led exporters’ cartel is now showing signs of squeezing global supplies to push prices back up.

The final quarter of this year, then, could see a combination of rising oil prices and low base effects, which would together send CPI inflation shooting up rather dramatically – enough, perhaps, to provoke earlier MPC action. While that’s conjecture, what can’t be denied is that yields on UK government debt have lately risen. Just a fortnight ago, as fixed-income investors celebrated an unexpectedly decisive Tory victory, avoiding the previously expected uncertainty of messy coalition-building and even a second election, the benchmark 10-year yield fell briefly below 1.90pc.

Since then, despite Osborne’s promise of “continued fiscal prudence”, yields broke above 2pc for the first time in almost six months, with bond prices subsequently falling. This is partly because the rising oil price is fuelling inflation expectations, together with a broader sell-off in eurozone bonds. But it would be wrong to attribute higher UK yields entirely to such factors.

For one thing, with a parliamentary majority, the Prime Minister must now deliver his promised referendum on EU membership. There is even talk that, with the majority so slim, and eurosceptic ire rising on the government backbenches, David Cameron may even be forced to stage the vote earlier than his pledged date of 2017.

It’s also lately become apparent that foreign investors are quitting UK government bonds, with non-residents selling a net £14bn in January and February – divesting faster than at any time since the dark days of early 2009, during the depths of the financial crisis.

This is part of a wider trend. The reality is that the prices of various Western sovereign instruments, for some time, have been inflated by printed money, blowing an enormous bond market bubble.
Having secured gains on the way up, investors are increasingly wondering when and how this QE story will end. That’s why some are now quitting a very crowded trade and taking profits, so avoiding the loss-incurring pain of any exit stampede. Such thinking partly explains recent skittishness on both US and UK sovereign bond markets.

In the case of Britain, though, there’s something else. Not only are our public finances still very fragile – with borrowing of £93bn during 2014-15, more than the previous fiscal year, and our national debt now above £1,500bn, nearly doubling over the last parliament.

We’re also sporting an external deficit – driven not only by fewer exports than imports, but also our external borrowings – amounting to a record 5pc of national income. In the case of UK gilts, then, investors are also starting to question the currency in which such bonds are denominated. And that only adds to the case to divest.

Which brings us back to deflation. There’s an argument doing the rounds among recently promoted Tory advisers that maybe the Government doesn’t need to worry too much about the deficit anymore. Perhaps the Bank of England can just do a bit more QE – and use that to keep suppressing bond yields. Hell, our central bank has already bought a third of the outstanding gilt stock, so why not a bit more? And now “real and present deflation” provides the perfect excuse for further “extraordinary monetary measures”.

That’s the greatest danger posed by last week’s UK deflation number, in fact. That it provides an alibi for myopic policymakers, flush with victory, to steer the UK into even deeper uncharted waters, engaging in yet more QE. For the bigger the bond market bubble, the greater the damage when it finally bursts.